Market Process

Austrian Criticism of Equilibrium Analysis

As might be expected, Austrians reject the mathematical equilibrium approach of neoclassical economics. The assumptions of the equilibrium models are intended to simplify rather than represent reality. Neoclassical economists claim that their models' predictions rather than assumptions are the point at which the models are empirically verifiable. The restrictive assumptions of equilibrium models, Austrians claim, lead to incorrect interpretations of events that lie outside those assumptions.

The source of Austrian disagreement with equilibrium models is the methodology of neoclassical economists. Neoclassical economists believe that economics, and indeed "all sciences," are empirical and dependent upon observation. Austrians point out the existence of purely logical sciences, including all of mathematics, whose conclusions (theories) are inherently valid given that their assumptions are valid. The statement that "2 + 2 = 4" is true whether two of anything are observed in the real world or not.

Austrians argue that economics is also a logical, not empirical, science. Economic data cannot be observed, because they are not present in the external world, but solely in the minds of acting individuals. Logic is valid for economics because and when the assumptions of economics are valid. That is, if a theory assumes that leisure is preferred to labor, then the theory is true only when that assumption is true. (A theory is true when its assumptions are true, even though its assumptions may not be directly observable.)

Economists cannot begin by collecting facts, and then constructing theories, because economic facts can only be collected if a theory of what is relevant is first made. Empirical observation can stimulate economists' interest in particular areas, or cause economists to re-evaluate their assumptions and logic, but can never lead to or verify a theory.

Austrians also disagree with the neoclassical interpretation of individual behavior as maximization. Maximizing assumes that consumers apply known means to known ends, and that firms face known cost and revenue curves. In this situation of perfect knowledge, the optimal course of action is implied by the data.

Austrians such as Ludwig von Mises, however, use a broader view of human behavior. The maximizing individual is a mere calculator. "Mises' homo agens, on the other hand, is endowed not only with the propensity to pursue goals efficiently, once ends and means are clearly identified, but also with the drive and alertness needed to identify which ends to strive for and which means are available" (Kirzner, p. 34). Any theory that assumes maximizing behavior cannot accurately assess behavior intended to actively search for and learn new data.

The Austrian criticism of maximization points to the fundamental criticism Austrians have of equilibrium analysis. Austrians believe assumptions should correspond to, not simplify, reality, and the assumption of equilibrium models that most violates this principle is the assumption of perfect knowledge. With imperfect knowledge, individuals must be alert to opportunities available on the market, including related information such as prices, qualities, costs and revenues. Austrians believe that such data "cannot properly be regarded as given facts but ought to be regarded as problems to be solved by the process of competition" (Hayek, p. 96). Theories that assume perfect information cannot correctly interpret activities that aim at gaining or spreading knowledge.

Some economists have tried to incorporate imperfect knowledge into equilibrium models, a logically inconsistent approach. For example, treating information as a good within an equilibrium framework must assume that consumers have perfect knowledge about the prices and quality of information, contradicting the hypothesis of imperfect information.

Austrians criticize other aspects of equilibrium analysis as well. Neoclassical economists use output (in the form of consumer and producer surplus) as a measure of efficiency and the model of perfect competition as a standard. However, consumers also value quality, which "offers compensations which, while not entering any output index, yet contribute to what the output index is in the last resort intended to measure" (Schumpeter, p. 82). Also, a model that makes assumptions that can never be met by reality should not be used as a standard against which to compare reality. Only possible situations should be compared to determine which best meets a certain goal.

Austrians have further criticisms of specific equilibrium models. Austrians argue that the model of perfect competition defines competition misleadingly, that models of imperfect competition view product differentiation and "selling costs" incorrectly, and that the model of pure monopoly misinterprets the nature of competition and its restriction.

In ordinary usage, 'competition' means a rivalrous process of trying to outdo one's competitors. But to neoclassical economists, 'perfect competition' is

the situation in which every market participant does exactly what everyone else is doing, in which it is utterly pointless to try to achieve something in any way better than what is already being done by others, and in which, in fact, it is not necessary to keep one's eyes open to what the others are doing at all. (Kirzner, p. 90)

The only relation the neoclassical concept of competition has with the concept of competition as a process is that perfect competition could possibly be seen as the result of the competitive process.

Some economists have incorrectly criticized the perfect competition model as not being able to account for innovation. In truth, innovation is incompatible with equilibrium models in general. Equilibrium models assume perfect information of all possible products and production methods, so that there is no scope for innovation. If the possibility of innovation exists, the market is not in equilibrium.

Models of imperfect competition claim that product differentiation leads to monopoly power. Austrians believe that the grouping of products as the same good is basically an arbitrary classification. Reality is at least as close to the opposite situation, in which no product is exactly like another, and products form a range of substitutes. Product differentiation may result from the nature of a particular good (such as most personal services) and have nothing to do with the presence or absence of competition. Or product differences may exist, as price differences may exist, at one time because equilibrium has not been reached.

The disparity between the neoclassical and ordinary definitions of competition leads to such paradoxical statements as "cutthroat" or "unfair" competition indicates an absence (or imperfection) of competition. In fact, all activities normally associated with competing economically, including cutting prices, improving quality, or trying to make consumers aware of a specific product, are considered by neoclassical economists to move markets away from 'perfect' competition. This confusion is primarily the result of the assumption of perfect information.

The assumption of perfect information leads neoclassical economists to misinterpret "selling costs" such as advertising expenditures. Selling costs are defined as costs designed to change consumer demand, and are distinguished from production costs which are designed to change the product (supply). Such a distinction requires a normative judgment on the part of the economist that a product has or has not "objectively" changed after some expenditure.

Some economists have misguidedly defended advertising as a means of spreading information. This allows orthodox economists to respond that "the basic objective of advertising is to persuade, not to inform" (McConnell, p. 605). In actuality, the role of advertising is to alert the consumer to the availibility and desirability of a product. With perfect information, such a role would indeed be unnecessary and unproductive. In reality, consumers do not have knowledge of all means available to them or of all ends they might find worthwhile. Advertising does not need to convey knowledge about goods as much as about the availability and desirability of goods.

The claim that advertising does not add to society's well-being also ignores the fact that consumers value advertising, as evidenced by the purchase of catalogs and cable-television "shopping channels."

The model of pure monopoly suffers from the same inadequate notion of competition as the other equilibrium models. Because competition is viewed as a situation, rather than a process, monopoly (the supposed complete absence of competition) can exist even when competitive activities exist. Monopoly is defined as a single seller, who is faced with downward-sloping demand, and thus produces results different from (and worse than) perfect competition.

In reality, a seller with no legal protection or monopolized access to resources is still under competitive pressure to make the best opportunities available to consumers. The neoclassical definition of competition again leads to a paradox, that the absence of competition ("pure monopoly") can be sustained by competition ("unfair" competition such as "aggressive" price cutting).

All in all, Austrians criticize equilibrium analysis, not because it is incorrect, but because it is irrelevant. Theories that make assumptions that can never be met in reality are useful only as a mental tool. Such theories can help economists isolate the effects of a given condition, such as imperfect knowledge, by showing what would happen if the condition were not present. They can help economists learn complex processes by focusing on one part at a time. But they cannot explain reality, and they cannot be used to judge reality.